Freytag v. C.I.R.

Decision Date06 July 1990
Docket Number89-4439,89-4440 and 89-4450,Nos. 89-4436,s. 89-4436
Citation904 F.2d 1011
Parties-5322, 90-2 USTC P 50,381 Thomas L. FREYTAG and Sharon N. Freytag, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Joe D. WOMBLE and Gladys E. Womble, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Bert C. TIMM and Mildred H. Timm, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Kenneth G. McCOIN and Candace G. McCoin, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
CourtU.S. Court of Appeals — Fifth Circuit

Richard J. Sideman, Ellen Israel Kahn, Sideman & Bancroft, San Francisco, Cal., for petitioners-appellants.

Gary R. Allen, Steven W. Parks, Kenneth L. Greene, William Rose, Jr., Asst. Atty. Gen., Michael L. Paup, Chief, Dept. of Justice, Tax. Div., Peter K. Scott, Acting Chief Counsel, William F. Nelson, Chief Counsel, IRS, Washington, D.C. for respondent-appellee.

Appeals from the Decision of the United States Tax Court.

Before GEE, POLITZ, and JONES, Circuit Judges.

POLITZ, Circuit Judge:

Thomas and Sharon Freytag, Joe and Gladys Womble, Bert and Mildred Timm, and Kenneth and Candace McCoin (Taxpayers) appeal adverse deficiency determinations made against them by the Tax Court. The court disallowed the Taxpayers' deductions for losses allegedly incurred as the result of investments in a commodity straddle program on the grounds that the program was composed of sham transactions or, alternatively, that the Taxpayers did not enter into these transactions primarily for economic profit. Finding error of neither law nor fact, we affirm.


The Taxpayers are four of approximately 3,000 taxpayers who have sought redetermination of deficiencies assessed against them for deducting losses allegedly realized from investments in straddles in forward contracts to buy and sell securities issued by the Government National Mortgage Association (GNMAs) and the Federal Home Loan Mortgage Corporation (FMACs). 1 The straddle portfolios in which the Taxpayers invested were all part of a computer-generated investment program offered by First Western Government Securities (First Western), formed in 1978 by Sidney Samuels, an attorney and former Internal Revenue Service agent. 2

We summarize the findings of the Tax Court, detailed in its exhaustive opinion, Freytag v. Commissioner, 89 T.C. 849 (1987), as follows: First Western identified prospective investors by using accountants, lawyers, and financial consultants it referred to as "finders." All First Western investors signed a customer agreement stating that First Western

may without demand for margin, whenever in [its] discretion [it] deem[s] it advisable for my or [its] protection, sell any or all securities or commodities held in any of my accounts ..., and [it] may borrow or buy any securities or commodities required to make delivery against any sale effected for me ... Such sale or purchase may be public or private and may be without ... notice to me and in such manner as [it] may in [its] discretion determine.

Investors informed First Western of their "tax preference," the amount of tax loss or long-term capital gain they wished to secure. First Western would respond by recommending portfolios of straddles based upon the requested tax-motivated action and the time remaining in the tax year. 3 Because of the high risk involved, the forward contract market in GNMAs and FMACs is dominated by institutional investors. Individual contracts in excess of $1.8 million in size and six months in duration are rare. The portfolios offered by First Western, however, had delivery dates ranging from 14 to as many as 30 months; those purchased by the Taxpayers involved over $1.6 billion.

In the typical scenario, investors would provide First Western with a "margin" deposit. Although a margin typically neither limits an investor's potential liability nor is linked to tax considerations, the "margins" paid by First Western's investors were a percentage of their desired tax loss and represented their total liability for trading losses. First Western assessed trading fees against the "margin" until a stated "fee cap" was reached, after which no fees were assessed.

As either the buyer or seller, a requisite in every transaction with its investors, First Western unilaterally set all prices. The Tax Court found that the predicates underlying First Western's pricing algorithm ensured that all of its contract prices would move in tandem with the price of the GNMA 9 1/2% coupon and in lockstep with each other.

It is the norm that marketplace investors enter into forward contracts intending to take or make delivery of the underlying security on a specified date. The mere possibility of delivery links the forward market to the cash market in the underlying securities. Delivery never occurred in the First Western program; in fact, First Western's computer program contained no delivery provision.

In lieu of delivery, and as a key element of its program, First Western closed out its investors' positions by cancellation or assignment, methods typically reserved for other kinds of situations. 4 When the loss leg of an investor's straddle achieved the desired tax loss, First Western would cancel the contract to ensure the investor a tax loss for the year. 5 Once the gain leg generated the desired amount of capital gain, First Western would assign the contract to one of three financial entities maintaining an account with it for this specific purpose. First Western closed out the contract with the assignee, credited the assignee's account with one percent of the proceeds, and credited the remaining 99 percent to the investor. No money changed hands.

First Western successfully obtained tax losses for its investors remarkably close to their stated tax preferences. 6 Unfortunately for the Taxpayers, however, the Commissioner marched to a different "tax preference" drummer. The Commissioner determined First Western's program to be a sham and denied the deduction of losses resulting from its transactions. Some 3,000 taxpayers petitioned the Tax Court for a redetermination. The Taxpayers were among ten test cases selected for a consolidated trial, which began in December 1984 before Judge Richard Wilbur. Judge Wilbur fell ill and Chief Judge Sterrett assigned the cases to a special trial judge for purposes of conducting the trial. Proceedings before the special trial judge were videotaped so Judge Wilbur could review testimony at home.

Judge Wilbur took senior status and the chief judge advised the parties that unless they objected he intended to assign their cases to the special trial judge for preparation of a report in accordance with 26 U.S.C. Sec. 7443A. One corporate petitioner objected and its trial was severed. Those remaining agreed to the reassignment with the understanding that Judge Wilbur or the chief judge would issue the opinion of the Tax Court, as required by Sec. 7443A(c). The special trial judge filed a proposed opinion finding First Western's transactions to be a sham or, alternatively, that its investors' losses were not deductible because they had not entered into the transactions primarily for profit. The special trial judge also recommended the levying of negligence assessments against the Taxpayers. The chief judge formally adopted the proposed opinion as the decision of the Tax Court. Following two unsuccessful motions for reconsideration, the Taxpayers appealed.

1. Jurisdiction of the special trial judge.

Pursuant to 26 U.S.C. Sec. 7443A the chief judge of the Tax Court may appoint special trial judges to preside over (1) any declaratory judgment proceeding, (2) any proceeding conducted under section 7463, (3) any proceeding where neither the amount of deficiency in dispute nor any claimed overpayment exceeds $10,000, and (4) "any other proceeding" so designated by the chief judge. 26 U.S.C. Sec. 7443A(b)(1)-(4). In the first three categories, the court may authorize the special trial judge to render a decision. 26 U.S.C. Sec. 7443A(c). Special trial judges may not render the formal decision of the Tax Court in cases assigned under the fourth category.

In the instant case, which fell under the "any other proceedings" category, the special trial judge filed his report on October 21, 1987. The chief judge adopted this report as the Tax Court's opinion and formally filed the decision that same day. The Taxpayers contend that by adopting the proposed opinion on the same day it was filed the chief judge in effect permitted the special trial judge to render the "decision" of the Tax Court contrary to 26 U.S.C. Sec. 7443A(c). Inasmuch as this argument is, in essence, an attack upon the subject matter jurisdiction of the special trial judge, 7 it may be raised for the first time on appeal. C.F. Dahlberg & Co. v. Chevron U.S.A., Inc., 836 F.2d 915 (5th Cir.1988).

Our analysis begins and ends with the simple fact that the opinion in this case was issued by the Tax Court in the name of the chief judge. The chief judge had both the obligation and power to maintain full responsibility for the decision in this case. Tax Ct.R. 183(c). 8 We will assume that the judge did so in good faith. The record before us is devoid of any evidence that even remotely suggests otherwise, other than the short time span between the filing of the special trial judge's report and the issuance of the Tax Court's opinion by its chief judge. 9

2. The Tax Court's determination of sham transactions.

The fundamental premise underlying the Internal Revenue Code is that taxation is based upon a transaction's substance rather than its form. Thus sham transactions are not recognized for tax purposes, and losses allegedly generated by such transactions are not deductible. See e.g., Gregory v. Helvering, 293 U.S. 465, ...

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